Why Printing Money Causes Inflation

Reader’s Question: Why does printing money cause inflation? Does this always occur?

Summary

  • If the money supply increases faster than output then, ceteris paribus, inflation will occur.
  • If a government prints extra money, households will have more cash and more money to spend on goods. But, if the amount of goods stays the same, the extra cash will just cause firms to put up prices.

friedman-quotes-inflation-800

Explanation of why printing money causes inflation

  • Suppose the economy produces 1,000 units of output.
  • Suppose the money supply (number of notes and coins) = $10,000
  • This means that the average price of the output produced will be (10,000/1000) = $10
  • Suppose then that the government prints an extra $5,000 notes creating a total money supply of $15,000; but, the output of the economy stays at 1,000 units.
  • Effectively, people have more cash, but, the number of goods is the same. Because people have more cash, they are willing to spend more to buy the goods in the economy.
  • Ceteris paribus, the price of the 1,000 units will increase to $15 (15,000/1000). The price has increased, but, the quantity of output stays the same.
  • People are not better off, and the value of money has decreased; e.g. A $10 note buys fewer goods than previously.

money-supply-inflation-link

Therefore, if the money supply is increased, but, the output stays the same, everything will just become more expensive. The increase in national income will be purely monetary (nominal)

If output increases by 5% and the money supply increases by 7%. Then inflation will be roughly 2%.

The Quantity Theory of Money

The Quantity theory of money seeks to establish this connection with the formula MV=PY. Where

  • M= Money supply,
  • V= Velocity of circulation (how many times money changes hands)
  • P= Price level
  • Y= National Income (T = number of transactions)

If we assume V and Y are constant in the short-term, then increasing the money supply will lead to an increase in the price level.

Printing money and devaluation

If a country prints money and causes inflation, then, ceteris paribus, the currency will devalue against other currencies.

Germany_Hyperinflation
Based on the values in Table IV (page 441) of The Based on ‘Economics of Inflation’ by Costantino Bresciani-Turroni, published 1937. Source: Wikipedia
  • For example, the hyperinflation in Germany of 1922-23, caused the German D-Mark to devalue against the currencies that didn’t have inflation.
  • The reason is that with the German currency buying fewer goods, you need more German D-Marks to buy the same quantity of US goods.

Examples of inflation caused by excess supply of money

bank notes
Bank notes in Germany in 1923 at the height of hyperinflation. ADN-ZB (Aufnahme: Oktober 1923)
  • US Confederacy 1861-64. During the Civil War, the Confederacy printed more paper money. In May 1861, they printed $20 million notes. By the end of 1864, the amount of notes printed had increased to $1 billion. It caused an inflation rate of 700% by April 1864. By the end of the Civil War, the inflation rate was hitting over 5,000% as people lost confidence in the currency.[“Inflation in US confederacy. Encyclopedia.com]
  • Germany 1922-23. In 1921 one dollar was worth 90 Marks. By November 1923, the US dollar was worth 4,210,500,000,000 German marks – reflecting the hyperinflation and loss in value of the German currency.

Evaluation – Link between money supply and inflation in the real world

  • It is possible, that if the government printed money, people could just decide to save the extra money and therefore, prices wouldn’t automatically rise.
  • It is also possible that increasing the money supply could stimulate more output. For example, in a recession, there is unemployment of resources and a lack of demand. If a government prints more money and households start spending more, this may encourage firms to start increasing output and investing in future capacity, which helps to cause an increase in real output. Therefore, the link between increasing money supply and inflation will be weaker.
  • Also in the real world, it is hard to measure the money supply (there are many different measures from M0 narrow money to M4 wide money)

However, the above provides a rough explanation why printing money usually reduces the value of money causing prices to increase.

Further reading

83 thoughts on “Why Printing Money Causes Inflation”

    • The central banks will give the money to the other banks thus the interst for the loans taken by the citizens and the companies will decrease so people get hike in their salary and they get loans for small amount .
      This means people are getting the currency indirectly.

    • In the case of the stimulus paid out to US citizens in 2020 and 2021, it was hard cold cash and lot’s of it. $1200 then $600 then $1400 and now they are considering a $2000 monthly payment to every citizen for six consecutive months, families with childredn began receiving $300 for each child up to four children per family, in addition to increasing benefits to social security recipients, and many tax credits for a number of expenses.

  1. I agree with Dan. The article said that if the government prints more money, then “…Effectively people have more cash…” That suggests that when the government prints more fiat money, then “people” effectively either get a raise in salary, or the price of goods falls. This does not happen of course. (Similarly, why would manufacturers raise prices of their products just because the government prints more fiat money? Or does some other “entity” set the prices of goods?) How can people spend more if they don’t have more? Sure, they can go in debt with credit cards, but debt is not equivalent to “effectively” having more cash”. The average person has no idea whether the government is printing fiat money or not. So, the article must mean something else, but it’s a total enigma to the reader not trained in economics. Economists need to explain specifically who the “people” are that “effectively” have more cash, and what “effectively” means. The article says it’s a “rough” explanation, but it’s a bit too rough I think.

    • Money is a representation of what the nation as a whole is worth. Printing more money (without destroying older currency) means that the value of the nation is split into even more pieces (ie cutting a pie into 10 pieces means each pie is smaller and worth less than if it were cut into 4 pieces, even though you still get 1 “slice”)….So, yes. Printing more money means we (the “people”) get more money in our pockets. Unfortunately though, it also means that the money in our pockets is now worth slightly less, requiring us to carry MORE of it around in order to do what we did BEFORE they printed more money (kind of like how things cost less when you were a kid than they do now as an adult.).

  2. What would cause inflation in a third world country where most of the people are poor and a few have gained tremendous wealth through corruption and looting

    • In situations like what you’re describing the value of money would either deflate ($1 now being worth say $1.50 since there’s less of it in circulation), or would become worthless since there isn’t enough in circulation to make the currency a viable means of exchange. This is why (or at least partially why) so many “3rd world countries” have currency values that are so low. Remember…the point of money is to facilitate trade…If there’s no trade being carried out in a given currency, that currency looses its value.

      To answer your question though, for there to be inflation in that type of scenario would require something (drought, flood, fire, destruction, etc) to destroy the available items with which to spend money on. In this case, having fewer items to purchase makes them more rare and hard to come by, and as such require more money to obtain which has the end effect of creating inflation.

  3. Still confused – to whom does the government give the new pieces of paper? How do they get into circulation?

    • Newly printed money is tipically given to employees working in the public sector, and/or to suppliers of goods to the state (military etc.).

      Printing money out of thin air, the government is effectively obtaining “something” in exchange of nothing: the difference is paid by the generality of the people holding the inflated currency, and can be regarded as a tax under all practical respects, but since it is invisible it is politically less dangerous.

    • That money adds to the governmebt budget, and it put in circulation when used e.g. to increase the public spend on services, or investments on infrastructures. In these days, to help businesses and adopt measures against unemployment.

  4. Has borrowing money from local or foreign citizens or foreign countries the same effect as printing money?

  5. Can inflation be controlled? I’m asking this in the wake of the COVID-19 outbreak. The government seem willing to print more money to prop up failing businesses. Once this COVID-19 passes then a great depression will set in. So in order to avoid this, can inflation be controlled.

    • People need to go back to work instead of sitting at home and collecting unemployment (which will just end up getting extended at election time) if we don’t start reopening businesses.

      I don’t believe we should sabotage our entire economy over a virus that is mainly affecting people that we can protect. We know who they are because they already have other diseases. Most people will fare well if they get Covid-19.

      Also, how many people are dying because they can’t get elective surgeries right now?Or because they don’t want to go to the hospital even though they have a heart condition or some other serious health issue? How many suicides has this issue caused? There are a lot of unknowns here.

  6. Inflation can be controlled until it can’t be controlled.

    Money printing cannot infringe the fundamental laws of the universe: nothing is created, nothing is destroyed.

    Much can be moved around, and possibly shifted in time, but nature will always win in the end.

  7. I have a doubt that has been killing me since I know what’s inflation. It make sense that if you print money, you will be adding supply but no demand, and that will make ur money be worth less. But, and here comes my doubt, who is the one that decides that money has to value less, who calculate it? “the market”, of course, but how? how did they know that is necessary to make money less value, how do they calculate it or even worse, why do they think it has to be done?

  8. I don’t get this.
    Printing extra money doesn’t mean people get more it just means there is more in circulation. It doesn’t automatically find its way into their accounts their wages stay the same so they don’t have any more to spend and they can’t withdraw more than they personally have.
    I’m sure there is an explanation but it’s lost on me!

    • If the government simply prints money and locks it in a vault, it does not contribute to inflation. They are talking about printing money and then circulating it into the population. This is done by issuing government contracts, hiring more government employees, or giving Gov’t funded incentives to businesses.

      If the supply of goods does not increase, and more people have money in their pockets … stores will ultimately charge more, as people will increase their offer as to not go without.

  9. This view of the relationship between printing money and inflation is way too simplistic and should not be encouraged. What was true in Germany in the 1920’s no longer applies. Technology and the Internet makes price comparison instant, this has an enormous deflationary effect. Printing money in recent times has lead to the growth of zombie companies, uber might be considered one, by being able to borrow almost unlimited amounts of money they have been able to operate for a decade having never turned a profit. Driving down prices for market share, this is the same for many Internet firms, the highly competitive nature means wafer thin margins and many operating at a loss – this printed money is loaned to them to survive in an environment where without it they would be bust, they operate at discount. This counteracts the inflationary nature of increased money supply, by cutting prices the firm in believes it is creating a future oligopoly or monopoly environment for themselves where the true cost of their goods and services can be realised. Then you get inflation

    The printed money also finds it way into assets, normally the stock market, but property also. Here the traditional model kicks in and we see inflation. These gains however are not spent on goods and services, they are hoarded by the super rich and new financial instraments and assets can be created and wealth made and lost as values rise and fall, but mostly rise. This rise is not considered as inflation, not measured by traditional gages rpi etc, the stock market going up is perceived a good thing. What it is actually creating is enormous inequality by limiting access to most of the wealth created by money printing to the elite.

  10. While I now understanding the nexus between money supply and inflation, I have one question that always ponders me. The currency that a central bank issues is part of its liability; is there any way to reduce this liability?

  11. Printing money is a hidden tax since you can not create wealth out of thin air. Governments are therefore imposing a hidden tax by taking value from all money for the newly created money. This is theft and is the reason why Islamic law says you should use something with an inherent value for money, is gold and silver coins. If we used such currency then governments would not be able to impose such hidden taxes whenever they please (usually for war to bail out rich bankers!).

Comments are closed.

Item added to cart.
0 items - £0.00